(Article from Registered Funds Alert, November 2016)
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On October 13, 2016, the Securities and Exchange Commission (“SEC”) adopted final rules regarding liquidity risk management and modernized data reporting for registered funds. We have summarized the initially proposed versions of these rules and some notable comments made by the industry in prior Alerts (available here, here and here). In this Alert, we focus on changes that the SEC made in response to industry comments, review potential examination and enforcement implications and discuss whether other pending asset management rulemakings will be adopted before the upcoming change in presidential administrations.
Liquidity Risk Management
The liquidity risk management rule is aimed at reducing the risk that open-end funds will be unable to meet their redemption obligations. The final rule follows the same basic structure as the 2015 proposal, but the SEC made substantial changes in response to industry comments that recognize the inherent challenges in making liquidity determinations. Relative to the proposed rule, the final rule better balances the SEC’s regulatory goals with practical considerations, resulting in a more flexible and administrable rule. The rule, and its attendant reporting requirements, do not apply to closed-end funds or business development companies (“BDCs”).
Rule 22e-4 will require that each registered open-end fund, including exchange-traded funds (“ETFs”) but excluding money market funds, adopt and implement a written liquidity risk management program. These programs must accomplish several specified goals, although ETFs that redeem shareholders in-kind are exempt from certain of these requirements:
- Assessment, management, and periodic review of the fund’s liquidity risk.
- Classification of the liquidity of each of the fund’s portfolio investments into one of four categories (does not apply to in-kind ETFs):
| Highly Liquid | can be converted to cash in three business days or less |
| Moderately Liquid | can be converted to cash in between three and seven calendar days |
| Less
Liquid | can be sold in seven calendar days or less, but will be expected to settle in more than seven days |
| Illiquid | cannot be sold in less than seven calendar days |
- Determine and periodically review a highly liquid investment minimum (does not apply to in-kind ETFs).
- Funds’ advisers will be required to determine their minimum percentage of highly liquid assets and implement policies and procedures that will enable them to respond to a shortfall from this percentage.
- Limit the fund’s illiquid investments to no more than 15% of the fund’s net assets (codifying long-standing SEC guidance).
- Funds will be required to review illiquid investments at least monthly. Breaches of the 15% limit must be reported to the fund’s board with an explanation and plan for remediation within a reasonable time period. If the breach is not resolved within 30 days, the board must determine whether the breach remediation plan is in the best interest of shareholders and investors.
The fund’s board is required to review and approve the fund’s liquidity risk management program when it is created, but it can designate that the adviser run the program. The board must receive and review an annual written report on the program’s efficacy. Additionally, in response to industry comments, the final rule clarified that the board is only responsible for general oversight of the program, and not specifically responsible for approving material changes or setting the highly liquid investment minimum.
Perhaps the most controversial component of the 2015 proposal was the “bucketing” that would have forced funds to classify each of the positions in their portfolios into six different categories based on how quickly they could be converted into cash (at a price that would not materially affect the position’s value). The overwhelming majority of commenters felt that this was an implausibly burdensome and somewhat unworkable system.
For instance, because the buckets were based solely on how many days it would take to convert a position into cash under the previously proposed system, many commenters argued that it would have been unclear and somewhat misleading when applied to certain types of assets where there is often a delay between the execution of an agreement to sell the assets and settlement. Bank loans, for instance, can be sold relatively quickly, but settlement can take significantly longer. Under the previously proposed system, these assets could have been viewed as effectively illiquid without regard to how quickly an agreement to sell the assets could have been reached, because the sole consideration was when the cash would arrive. The new rule addressed this shortcoming. The adopting release makes it clear that the Less Liquid category in the final rule is meant to include asset classes, such as bank loans, where a delay between executing a sales agreement and settlement is common, and provides that they need not be treated as illiquid assets. Nonetheless, by categorizing such assets as “Less Liquid” in the final rule, many funds that are in fact highly liquid will appear on these metrics as less liquid than funds in similar asset categories. As a note of caution, however, the adopting release includes guidance that at a certain point the length of the settlement delay may justify an asset being treated as an illiquid asset. In this respect, the SEC cites as an example low-quality loans that “may not settle for a number of months.”
In addition to addressing some of the substantive issues with the proposed rule identified by commenters, the final rule also has salient changes that reduce the practical hurdles with implementation. Many commenters felt that the previously proposed classification requirement was unduly burdensome because it required that each position be classified individually, which would have potentially required evaluating liquidity on a security-by-security basis. The final rule allows for determinations to be made for entire asset classes, unless a particular investment has characteristics that differ from the fund’s other holdings in that asset class, making determinations for individual securities the exception rather than the rule. This change, like many of the other changes, seems to stem from a recognition that exact determinations of a security’s liquidity are problematic because liquidity is ephemeral, and requiring statements of certainty on liquidity leaves the misimpression that liquidity determinations are a science, not an art.
In the same vein, the final rule revises the consequences of a fund failing its high liquidity minimum percentage test. Under the proposed rule, the fund would be prohibited from purchasing any securities other than highly liquid securities until the ratio was restored. Under the final rule, however, funds may continue to buy non-highly liquid securities pursuant to adopted shortfall policies and procedures and report that occurrence to the fund board at its next scheduled meeting.
“The final rule allows for determinations to be made for entire asset classes, unless a particular investment has characteristics that differ from the fund’s other holdings in that asset class, making determinations for individual securities the exception rather than the rule. This change, like many of the other changes, seems to stem from a recognition that exact determinations of a security’s liquidity are problematic because liquidity is ephemeral, and requiring statements of certainty on liquidity leaves the misimpression that liquidity determinations are a science, not an art.”
Despite the positive changes to the liquidity management rule, it is still a complex set of rules and requirements that will require substantial compliance resources. Even though the compliance date is December 1, 2018 for fund groups with $1 billion or more in assets and June 1, 2019 for smaller fund groups, funds and other market participants would be well advised to begin thinking about implementation sooner rather than later.
Data Reporting
The final rule release for modernizing investment company reporting largely adopts the disclosure regime put forth in the proposing release, which we summarized in a prior Alert. Generally, the SEC adopted a new monthly reporting requirement on new Form N-PORT, with the first and third fiscal quarter reports including an exhibit of portfolio holdings that will replace current Form N-Q filings, and a new census filing on Form N-CEN that will replace current Form N-SAR filings.[1] Each of the new filings will be required to be made electronically in structured XML format, which will allow the SEC and investors to compile and analyze reported data more easily.
In response to industry comments, the SEC made certain changes to the proposed data reporting requirements or clarified the requirements in the final release. Some of the key changes include:
- A fund may respond to certain items that involve subjective judgment calls by using its own methodology and conventions, or those of its service provider, so long as the fund reports similar information internally and to investors in the same manner. Funds also now have the opportunity to explain their methodologies, including any assumptions.
- If a fund invests 25% or more of its assets in debt instruments, or derivatives that provide that level of notional exposure to debt instruments or interest rates, it must provide a portfolio-level calculation of duration and spread duration across the applicable maturities in its portfolio. This threshold was initially proposed to be set at 20% of fund assets. Additionally, the threshold is based on the three-month average of a fund’s assets as opposed to being calculated on the reporting date as initially proposed. The SEC also streamlined the potential maturities that a fund would need to calculate, retaining three-month, one-year, five-year, ten-year and thirty-year maturities while dropping the requirement to calculate spread and spread duration for one-month, six-month, two-year, three-year, seven-year, and twenty-year maturities.
- For derivatives that have underlying assets that are non-public indices or custom baskets of assets, the SEC has modified its original proposal regarding reporting of the underlying components of such indices or baskets. A tiered reporting structure has been adopted such that (i) if an investment in a non-public index or custom basket makes up more than 1% but less than 5% of a fund’s net assets, the fund must report the top 50 components and (ii) if an investment in a non-public index or basket makes up more than 5% of a fund’s net assets, all components must be reported. The SEC initially proposed disclosure of all components representing more than 1% of net assets.
- With respect to securities lending, the SEC has replaced the proposed requirement to disclose the terms governing compensation of a securities lending agent, including any revenue split, with a requirement to disclose actual fees paid during the reporting period.
- The SEC has responded to industry requests that certain reported information not become public by agreeing to keep a small number of items confidential. These include the following, and any explanatory notes related to these items:
- Position-level risk metrics (delta);
- Country of risk and economic exposure;
- Position-level liquidity classifications; and
- A fund’s highly liquid investment minimum.
When the new reporting requirements become effective, funds will be required to file Form N-PORT within thirty days of the end of each calendar month and Form N-CEN within 75 days of the end of the fund’s fiscal year. With respect for Form N-PORT filings, only those filings made after the month ending the first and third fiscal quarters will be made public (which is why those particular filings must include an exhibit reflecting a schedule of investments akin to current Form N-Q). Many commenters requested that the SEC provide additional details regarding its cybersecurity preparedness to safeguard the non-public information that will be reported on Form N-PORT. However, in the final release, the SEC only briefly addressed this issue, stating that it has experience maintaining confidential information and is working on controls and systems to handle confidential information submitted on Form N-PORT.
The compliance date for the new data reporting requirements will be June 1, 2018 for a “group of related investment companies” with net assets of $1 billion or more, and June 1, 2019 for smaller fund groups. The SEC plans to allow funds to file test filings during a trial period in advance of the compliance date. Notably, all information on Form N-PORT filings made within six months of the June 1, 2018 compliance date will not be made public (other than the portfolio holdings exhibit required to be filed for funds’ first and third fiscal quarters that is similar to current Form N-Q filings). The SEC believes that this six-month period will allow filers and the SEC to make any technical adjustments needed to fine-tune the filing process with respect to new Form N-PORT. Additionally, with respect to reporting requirements arising out of the liquidity risk management rule release, funds will have an additional six months (December 1, 2018/2019 for large/small fund groups) before reporting that information.
Examination and Enforcement Implications
The new reporting requirements will result in the SEC having significantly more, and more detailed, information about funds and their portfolios. The SEC openly acknowledges that the new reporting requirements will facilitate examination and enforcement efforts. For example, Form N-CEN will include numerous “Yes” or “No” questions. With respect to such questions, the SEC stated that “staff of our Office of Compliance Inspections and Examinations may rely on responses to flag questions in Form N-CEN to indicate areas for follow-up discussion or to request additional information.” One area where this could put a fund on the SEC’s radar is with respect to NAV errors, as open-end funds will need to check “Yes” or “No” in response to the question of whether they made any payments to shareholders or reprocessed shareholder accounts as a result of a NAV error.
The volume of detailed information that the SEC will have on each fund could open the door for significant advances in the SEC’s ability to compile and analyze information related to a single fund or identify industry trends. Notably, it also will enable the SEC to compare the practices of various funds that pursue similar investment strategies. For example, part of the SEC’s rationale for deciding that certain items to be reported on Form N-PORT, such as position-level risk metrics or position-level liquidity classifications, will not be made public was that the public would not be able to compare how different funds evaluate the same investment. The SEC, however, will be able to make these comparisons and included an explicit statement in the instructions to Form N-PORT that it may use such information in examinations, investigations and enforcement proceedings.
Electronic Delivery of Shareholder Reports and a Potential Pocket Veto for the Derivatives and Business Continuity Rules
While the SEC had proposed a rule that would make electronic delivery of fund shareholder reports the default option in the same release in which it proposed to modernize data reporting, the electronic delivery rule has not yet been adopted. In the days leading up to the release of the final rules discussed above, it was reported that Commissioner Piwowar had expressed his belief while speaking at a conference that he did not expect the SEC to be in a position to vote on final rules for two key asset management rulemaking initiatives before a change in presidential administrations—derivatives and business continuity/transition planning.
The delay of the electronic delivery rule did not sit well with Commissioner Piwowar. In his statement at the open meeting related to the adoption of the liquidity risk management and reporting rules, Commissioner Piwowar said he would “agree to delay” non-essential items and rulemakings if the SEC did not finalize a rule regarding electronic delivery of fund shareholder reports. While he agreed to vote on a consolidated audit trail release, final rules for capital and margin requirements for security-based swap dealers and two other releases that are actively being considered, Commissioner Piwowar did not expressly name derivatives and business continuity/transition planning as those two releases. While purely an exercise in reading tea leaves at this point, Commissioner Piwowar would have the power to effect a form of “pocket veto” given that the SEC currently has only three commissioners. SEC rules state that three commissioners are required for quorum to conduct business (i.e., to vote on rules). By simply declining to attend a meeting, any current commissioner could prevent a vote on any pending rulemaking. This power gives Commissioner Piwowar some leverage to force adoption of the electronic delivery rule in exchange for the derivatives and/or business continuity/transition planning rules. While the results of the presidential election could independently derail the derivatives rule, it is possible to view Commissioner Piwowar’s displeasure with the failure to adopt the electronic delivery rule, combined with his public statements that some rules are unlikely to be finalized before Inauguration Day, as a suggestion that he would use his ability to prevent the SEC from achieving quorum to vote on other pending rules.
On November 1, 2016, however, the SEC’s Division of Economic and Risk Analysis published a memorandum outlining its economic analysis of certain potential risk-adjusted schedules to determine a fund’s derivatives exposure and qualifying coverage assets under the proposed rule’s requirements. The release of this memorandum could be an indication that the Chair still intends to call for a vote on a final derivatives rule prior to the end of her term. The memorandum is a direct response to numerous comments suggesting the SEC consider adding some method of accounting for the variance in risk among different asset classes in the final rule. The economic analysis contained in the memorandum appears to generally support the incorporation of risk adjustments and haircuts, which would be a positive development for funds that utilize derivatives. In the SEC press release accompanying the release of the memorandum, the SEC stated it would accept comments on the new economic analysis, but did not provide a deadline.
[1] In line with current reporting requirements, BDCs are not subject to these reporting requirements.